Nobody writes anything positive about either Fannie Mae or Freddie Mac (the GSEs) lately. However believing that credit should go where credit is due I would remedy that.

Freddie Mac – more than almost anyone in the market got the recent interest rate shift right. That matters because (if you have not noticed) by far the biggest thing that has happened in financial markets in the last few weeks is a very rapid rise in long bond interest rates. And Freddie Mac is very exposed if they get their hedging wrong.

Given that the risks of Freddie’s exposure lie mainly with taxpayers this is something that should be celebrated.

So I am celebrating it.

Background

The GSEs own lots of 30 year fixed rate mortgages. Nearly a trillion dollars worth each (Freddie is smaller).

Those assets become less valuable as interest rates rise. If rates for instance went up to 8% then there would be very substantial losses from holding a trillion dollars 30 year 5.5 percent fixed rate mortgages.

The GSEs can reduce this risk by either selling some of their owned mortgages or by changing their funding mix so they have fewer short term borrowings and more long term fixed rate borrowings.

Unfortunately as the GSEs remove their risk of rising rates they reduce their profits. After all it is very profitable for a GSE to borrow short (at rates close to zero) and lend at above 5% in new well collateralised fixed rate mortgages. Or it would be profitable until rates rose.

Until the end of the first quarter the GSEs were lending very large amounts funded largely short term. Freddie in particular noted (complained?) in their first quarter SEC filings that they were being pressured by regulators to grow their balance sheet to make funding available to the housing market.

And so they grew their balance sheet funded largely short term. The incremental business was highly profitable but carried a large risk of interest rate rises. (Fully hedged Freddie noted that the business was at best marginally profitable.)

When I read the Freddie quarterly SEC filings I looked at this interest rate risk – and thought – oops – here the taxpayer goes again.

But it was not to be. During April (reported in monthly data) Freddie turned on a dime and started selling mortgages, reducing their floating rate funding and increasing their fixed rate funding. They did this just before interest rates spiked.

Freddie Mac got it right.

You can see this in this monthly series. Note that the mortgage portfolio shrunk at an annualised rate of 50.9 percent – the fastest I can remember and probably the fastest ever. Moreover almost all this shrink was in long-dated fixed rate mortgages.

Freddie’s fixed rate debt increased from 582 to 603 billion – with an even larger reduction in floating rate debt.

There are plenty of people in privately run financials who wished they traded that well. All those people carted out by the sudden shift in interest rates for instance.

I know there is revulsion at paying high salaries to executives at financial institutions that have received government bail outs. But someone at Freddie Mac deserves a big bonus – a really big one.

Memo to Senator Dodd: don’t complain too much about it when the bonus gets paid.

John

PS. Fannie Mae’s portfolio moves were in the right direction but nowhere near the scale of Freddie Mac. I hope and expect that the bonuses will be smaller at Fannie Mae.

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